Project finance at a crossroad: why hedge fund involvement may change governmental monetary policy
November 2013 | PROFESSIONAL INSIGHT | FINANCE & INVESTMENT
Financier Worldwide Magazine
The drying wells of cross-border bank lending will likely have a significant impact on the capabilities of countries in the emerging and developing world to plan and execute large projects in their pursuit of industrialisation and modernisation. European banks, long the dominant lenders for cross-border project finance, are retreating. The combination of the 2007-09 banking crisis and its lingering aftermath, the eurozone debt crisis, the new Basel III requirements, and new European Authority banking regulations, have compelled European banks to boost capital by reducing their balance sheets (The Economist, 21 April 2012). In particular, the International Monetary Fund projects that European banks will undergo a $2.6 trillion deleveraging between 2012 and 2014. Consequently, European project financing is undergoing a significant retrenchment. Although Japanese and Canadian banks have increased project finance involvement, those increases are insufficient to fill the void created by reduced European bank lending. As a result, many large scale projects worldwide will need to be either scrapped, scaled down or forced to seek new, but less favourable, financing.
Project finance is defined as “the raising of finance on a limited recourse basis, for the purposes of developing a large capital-intensive infrastructure project, where the borrower is a special purpose vehicle [SPV] and repayment of the financing by the borrower will be dependent on the internally generated cashflows of the project” (David Gardner and James Wright, Project Finance).This type of financing is called ‘cashflow lending’, which, in contrast to corporate lending where lenders have recourse in the borrower’s assets, limits a lender’s recourse to the project’s future cash flows. As such, stakeholders, known as sponsors, are not liable for a project’s failure.
Structured finance, which includes project finance, is “the practice of arranging for a lender to make a loan under conditions that are structured so as to free the lender from concern over the credit-worthiness of the borrower” (Carl S. Bjerre). Unlike conventional secured lending, structured finance borrowers and the borrowers’ assets are legally distinct, thereby decreasing structured finance lenders’ exposure to a borrower’s bankruptcy risk. Consequently, otherwise low-credit borrowers are able to obtain much-needed financing.
Generally, sponsors are entitled to the project’s profits, but debt service to lenders takes priority over sponsor equity shares. If there is more than one sponsor, which is often the case with large projects, a shareholder agreement would govern. Such an agreement might contain pre-emption rights, conflict and dispute resolution, voting rights, management and profit sharing.
The sponsors and lenders enter into an ‘off-take agreement’ with a buyer, called the off-taker, to purchase a certain amount of the future production. These agreements are generally negotiated long before the construction of a facility “to guarantee a market for the facility’s future production and improve chances of getting financing for the installation concerned” (Business Dictionary).
Multinational, multilateral project financing is complex because it deals with a vast array of parties, interests, regulations and currencies, and is subject to shifting political climates. Parties also need to consider logistical and cultural issues. As such, due diligence prior to and crisis management during a project is key.
Parties to international project finance are challenged with currency risk because many projects are located in countries that have unstable economies. Often, the off-take agreement provides borrowers with payment in local currency or floating payment in local currency that is pegged to a stronger currency, such as the dollar or euro. It follows, therefore, that any significant movement by either the local currency or by the pegged currency can impact investor returns.
To hedge against exchange rate variations, lenders may want to purchase currency swaps. Currency swaps provide participants the ability to hedge against exchange rate variations due to market volatility. A project finance lender may purchase a swap to lock in today’s exchange rate. However, the lender will consider the purchase price of a currency swap as a factor in its decision to participate in a project. It must also find a currency swap seller, which may be difficult or uneconomical when the project is in a developing country, especially one rife with political or economic instability.
Moreover, the project’s success can actually trigger currency risk. If the project is producing goods for export, the host country may want to devalue its currency to strengthen its export market. Consequently, investors will receive devalued proceeds from the project’s receivables, despite the project’s success. In other words, a project’s success may be a double-edged sword. Therefore, prior to investing, a project finance lender’s due diligence should also include an analysis of payment expectation even if the project is successful.
Hedge fund investing
Due to the retreat of European banks and insufficient funds in their place, SPVs in emerging and developing countries in need of or engaged in a project may look to hedge funds for initial or continuing project finance. With bank project financing, a bank’s relationship with its central bank compels it to act within certain parameters that comply with a central bank’s goals and global perspective. A hedge fund, unlike a bank, has no such relationship with a central bank, so it would likely lack such a perspective. As a consequence, hedge fund involvement in project finance may materially affect a sovereign’s currency.
A central bank’s role in an economy is to manage its sovereign’s currency, money supply and interest rate. Due to the interconnected, international economy, central banks take measured actions that are globally focused. Since commercial banks have a mismatch of assets and liabilities and are subject to liquidity drains, they are reliant on central banks to help maintain solvency and liquidity. As a result of this reliance, commercial bank project finance activity would likely be with an eye towards the broader financial system.
In contrast, hedge funds have no such reliance on central banks, so their project finance activity would likely be free to have a local and therefore profit-only focus. Once the welfare of the global economy is not a concern, hedge fund project financing could possibly be a gateway for an unfavourable impact on a sovereign’s currency.
A hedge fund’s damaging impact on a sovereign’s currency is, in fact, nothing new. In 1997, George Soros’s Quantum Fund, together with other funds, made a complicated bet on the Thai baht, causing the baht and other currencies to fall dramatically, leading to dramatic Forex gains. The baht had been pegged to the dollar and much business was conducted in dollar-denominated bahts. Six months prior to the decline of the baht, hedge funds, betting that the baht would depreciate, shorted the baht by borrowing bahts, converting them into dollars, and later repaying creditors in bahts. The speculative borrowing, among other factors, pressured the Thai government to unpeg and float the baht, causing major baht declines and a financial panic. When the baht tanked, those hedge funds profited handsomely. The financial panic in Thailand then spread to other Southeast Asian countries, leading to the 1998 Asian financial crisis.
To illustrate how hedge fund autonomy can impact a currency, imagine that a sponsor, who is also the government of a developing country, undertakes a large project to supply its citizens with hydraulic power. Due to the new banking restraints, European banks can no longer provide funds for this project. However, the sponsor/sovereign cannot scrap this important project, so it must obtain alternative sources of funding. A hedge fund agrees to fund the remainder of the project until completion, but stipulates that during the duration of the project the sponsor/sovereign will not devalue its currency, which would be to the detriment of the hedge fund. This stipulation, however, may harm the sponsor/sovereign because it may want to strategically devalue its currency to expand its export market, which may include the hydraulic power from this project.
This example is much more likely with a hedge fund than a bank because of a bank’s link with a globally-focused central bank. In addition, some of its other clients may want to purchase the hydraulic power, so currency devaluation may be beneficial. On the other hand, a hedge fund, for self-protection of a non-recourse loan, may condition project financing on a currency status quo. The sponsor/sovereign may feel compelled to accept these terms because the project is too vital to scrap and it cannot procure alternate funds.
Furthermore, under this scenario, the sovereign/sponsor may pressure the SPV to accelerate the project’s completion date, thereby decreasing the time that a sovereign relinquishes full control of its currency. Such acceleration may be detrimental, as it can harm the quality of the project. Therefore, a hedge fund involved in project finance would likely need to condition its project investment on responsible project management, including a clause banning acceleration that compromises quality. Thus, through project finance, a hedge fund can exert a measure of control over a sovereign’s currency.
The changes in European banking law and practice will considerably affect project finance, especially those projects in the emerging and developing world. To keep current, large scale projects afloat, sponsor/sovereigns must now secure financing from other sources. Although hedge funds would likely be the supplier of those funds, they may insist on a bar to currency devaluation as a precondition to lending. If so, the shift from project finance bank lending to hedge fund investing will be more than just a shift in the source of the funds; it may very well cause a shift in governmental economic and monetary policy.
Ari Mushell is a staff attorney at Americans United for Government Reform. He can be contacted on +1 (732) 598 4666 or by email: firstname.lastname@example.org.
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Americans United for Government Reform